Wednesday, December 23, 2015

Much of what we learn and practice as investors represent models and
methods developed in a different age, one where the market was composed
of consumer product, infrastructure and manufacturing companies. While
those lessons may have been good ones for old economy markets, I will
argue in this post that they can provide misleading signals with short
corporate life-cycles, an affliction common among, but not unique to,
tech companies. Lest this be construed as an attack on a specific group
of investors, I will spread my critique across investor classes,
starting with value investors, then moving on to growth investors and
market timers and then turning it on intrinsic valuation practitioners
(which is where I count myself).

The Tech Challenge for Value Investors

If you are a value investor, you may have been told that everything you
need to know about valuation is in Ben Graham's Security Analysis. I
will make a confession. I love Ben Graham for his philosophy and
intellect, but I think that using the techniques suggested in it to
value tech companies is akin to using a hammer to do surgery. It is not
Graham's fault, since he wrote the book at a time when the corporate
world was populated with railroads, utilities and manufacturing
companies and much of his advice was directed at coaxing investors who
were more interested in buying bonds, to consider stocks as an
alternative. In fact, in the Graham world, a good stock looks like a
perpetual bond, with ever-growing coupons. So, at the risk of arousing
the ire of value purists, here is my list of old value investing
chestnuts that need to be roasted on the tech fire.

1. Don't trust earnings multiples: There are some pricing
metrics that are singularly inappropriate for use with tech companies,
and at the top of the list is price earnings (PE) ratios. Early in the
life cycle, when growth is explosively high and R&D expenses are
rising, the PE ratios for tech companies will be high, as markets price
in future earnings, and tech companies will almost always look
expensive, even if they are fairly priced. Later in the life cycle, when
growth is not just low but often negative and R&D expenses are
falling, the PE ratios for tech companies will be low, and tech
companies will look cheap, even when they are not.To
illustrate this dynamic, I created two companies, both with 20-year
windows and similar risk, but made one a tech company, with intense
growth (50%) for the first 5 years, a short mature period of 5 years
(10%) and speedy decline thereafter and the other one a non-tech
company, with less intense growth (25%) for the first 5 years, a longer
mature period of 10 years and a more stable afterlife. The graph below
shows the fair PE ratios for these firms, as they move through their
lifetimes. The bottom line is that tech companies look expensive on a PE
ratio, when they are young, and cheap on a PE ratio basis, when they
age, even if they are fairly valued. This problem is exacerbated by the
accounting mistreatment of R&D, which makes young tech companies
look less profitable than they truly are and old tech companies more
profitable. Multiples of revenues and book value are also affected, but
not to the same degree.

I can offer some evidence for this proposition from my post on the aging of tech companies,
where I classified all companies based on their age and compare old
tech companies (older than 35 years) with old non-tech companies. In the
graph below, I compare the earnings multiples at which old tech
companies(>35 years) trade, relative to old non-tech companies:

Old companies = Age greater than 35 years (since founding)

Note that old tech companies look cheap on every earnings metric,
relative to old non-tech companies. There may be a reason why companies
like IBM and Microsoft keep showing up on the lists of cheapest stocks,
when you run value screens.

2. Don't buy and hold "good" companies: Not all value investors
subscribe to this notion, but quite a few seem to accept the idea that
if you find a good company (well managed, with strong competitive
advantages), you should buy the company for your portfolio and hold for
the long term (perhaps forever). That is not good advice with tech
companies, where today's tech superstar can become tomorrow's dog. If
you buy a tech company, you should be revaluing it at frequent
intervals, selling it, if the price exceeds the value significantly....